• The average rate of return, sometimes called the •
accounting rate of return, measures the average income as a percent of the average investment. The average rate of return is computed as follows: Estimated Average Annual Income Average Rate of Return = Average Investment o
Assuming straight-line depreciation, the average investment is computed as follows: Initial Cost + Residual Value Average Investment = 2
The average rate of return has the following three advantages: o o
It is easy to compute. It includes the entire amount of income earned over the life of the proposal. It emphasizes accounting income, which is often used by investors and creditors in evaluating management performance.
The average rate of return has the following two disadvantages: o o
It does not directly consider the expected cash flows from the proposal. It does not directly consider the timing of the expected cash flows.
• An investment in fixed assets may be viewed as • •
purchasing a series of net cash flows over a period of time. The timing of when the net cash flows will be received is important in determining the value of a proposed investment. Present value methods use the amount and timing of the net cash flows in evaluating an investment.
• The net present value method compares the amount to be invested with the present value of the net cash inflows. o
It is sometimes called the discounted cash flow method.
• The interest rate (return) used in net present value •
analysis is the company’s minimum desired rate of return. It is sometimes termed the hurdle rate. If the present value of the cash inflows equals or exceeds the amount to be invested, the proposal is desirable.
• When capital investment funds are limited and the
proposals involve different investments, a ranking of the proposals can be prepared using a present value index. The present value index is computed as follows: Total Present Value of Net Cash Flow Present Value Index = Amount to Be Invested o
When equal annual net cash flows are expected from a proposal, the internal rate of return can be determined as follows: o
Step 1. Determine a present value factor for an annuity of $1 as follows:
Step 2. Locate the present value factor determined in Step 1 in the present value of an annuity of $1 table (see slide XX) as follows: Locate the number of years of expected useful life of the investment in the Year column. Proceed horizontally across the table until you find the present value factor computed in Step 1.
Identify the internal rate of return by the heading of the column in which the present value factor in Step 2 is located.
The internal rate of return method has the following three advantages: o o o
It considers the cash flows of the investment. It considers the time value of money. It ranks proposals based upon the cash flows over their complete useful life, even if the project lives are not the same.
The internal rate of return method has the following two disadvantages: o
It has complex computations, requiring a computer if the periodic cash flows are not equal. It assumes the cash received from a proposal can be reinvested at the internal rate of return, which may not be valid.
• The impact of income tax on capital investment decisions can be material. o
For example, in determining depreciation for federal income tax purposes, useful lives that are much shorter than actual useful lives are often used. Also, depreciation for tax purposes often differs from depreciation for financial statement purposes. As a result, the timing of the cash flows for income taxes can have a significant impact on capital investment analysis.
Some advantages of leasing a fixed asset include the following: o
The company has use of the fixed asset without spending large amounts of cash to purchase the asset. The company eliminates the risk of owning an obsolete asset. The company may deduct the annual lease payments for income tax purposes.
A disadvantage of leasing a fixed asset includes the following: o
It is normally more costly than purchasing the asset. This is because the lessor (owner of the asset) includes in the rental price not only the costs of owning the asset, but also a profit.
• Price levels normally change as the economy improves or deteriorates. o
General price levels often increase in a rapidly growing economy, which is called inflation. During such periods, the rate of return on an investment should exceed the rising price level. If this is not the case, the cash returned on the investment will be less than expected.
• Price levels may also change for foreign investments. o